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Pension Plans Take a Beating

Continued decline in plan funding suggests more companies will back away from pensions.

The funded status of traditional pension plans has deteriorated again this year, leaving companies that sponsor plans with quite a hole to climb out of in coming years and suggesting more companies will freeze or close such plans.

“2012 so far has been a difficult year for pension plan sponsors,” says Jonathan Barry, who leads Mercer’s defined-benefit risk consulting efforts for its U.S. retirement risk and finance business. “Even though we’ve had decent equity returns for the year, interest rates have dropped so much that the majority of U.S. pension funds’ funded status has declined.”

Mercer calculates the aggregate deficit of defined-benefit pension plans operated by S&P 1500 companies totaled $689 billion at the end of July, up almost $200 billion from the shortfall at the end of last year. It estimates the plans’ aggregate funded ratio has fallen to 70%, down from 75% at the end of 2011 and 81% at the end of 2010.

“If you ended the year right there, that’s going to mean very large balance-sheet adjustments, very large P&L hits for 2013, very large cash contribution requirements,” Barry says, summing up the pension situation as putting “a lot of pressure on companies.”

Underfunding has increased even though companies have poured money into their plans over the last few years; Mercer estimates plan contributions exceeded $70 billion in 2009, 2010 and 2011. Barry says that companies are likely to continue making big contributions. “To be honest, that’s probably going to be the primary tool to remedy the deficits, cash funding.”

A recent Mercer report notes a significant increase in the number of S&P 1500 plans it considers risky, an assessment that takes into account both the plan’s funded status and the materiality of its obligations given the company’s overall size. In 2011, 7.1% of S&P 1500 plans fell into the risky category, up from 4.7% in 2010.

In addition to the continued low levels of interest rates and volatile financial markets, the Mercer report notes points to other factors affecting plan funding. The Moving Ahead for Progress in the 21st Century Act enacted this summer gave companies leeway to lower their funding requirements. At the same time, the legislation increased the premiums that plan sponsors pay to the Pension Benefit Guaranty Corp.

Mercer also notes a change in the Society of Actuaries’ mortality assumptions that Barry says could boost plans’ liabilities by 2% to 8%, depending on a plan’s demographics and whether it pays lump sums or annuities.

Given the financial pressure on plan sponsors, Barry says it’s likely that more companies will choose to freeze or close plans. “This is a trend that’s been going on for the last several years at a pretty good clip and I don’t see that slowing down.”

He’s not expecting lots of plans to follow Ford and General Motors’ lead in offering to buy out retirees, noting that doing so requires a certain level of funding, as well as a certain size. “Our general thinking is that retiree cash-outs are more relevant to very, very large plan sponsors, multibillion-dollar plan sponsors.” Barry does expect to see smaller-scale efforts that target former employees who haven’t yet retired.

Amid the continued market volatility, Barry sees more companies adopting liability-driven investing, in which they rely more heavily on fixed-income investments to avoid a mismatch between the behavior of their assets and liabilities. And he notes an increasing interest in dynamic investment policies, in which a company sets out a plan to change its asset allocation over time, using changes in the plan’s funded status as the trigger for changes.

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